0:00

Hopefully, you've given it some thought and, even more so, tried to do some

number-crunching. And, by the way, this number-crunching is

extremely important because it affects the cost of capital and the cost of capital is

very important because of? I haven't reminded you of this question.

Compounding, right? Okay, let's get started.

I know that beta's determined risk so I know this equation.

Beta asset is equal to beta equity, if what's true?

There is no debt. But then, it's weighted by equity over D

plus equity plus beta debt weighted by D over D plus E.

Okay? If you stare at this equation, it won't be

very surprising that you can rewrite it as beta equity, but, okay?

And what you can do is, do this on your own.

You can write beta equity as, you've seen this equation before.

Beta asset, business risk plus D over E beta asset minus beta debt.

Okay, so this is just a transformation. I've just transformed this to this.

These are essentially the same thing. Okay, quick question.

What is the cost of capital of the project?

The first thing you have to figure out is what the cost of capital of what project

are we talking about? Let me put S here.

1:41

An S here. So, the risk of the assets of the software

business is what we are after. But then, I told you the numbers.

What numbers did I give you? I gave you numbers for beta equity.

So, what was the beta equity? Beta equity was 1.40 is equal to beta

asset, the unknown, plus, I told you on average the ratio of debt to equity was

how much? 0.25, remember?

All the data is with you. And which is, which is this industry?

S, software industry, beta asset. Again, the unknown, 'till now we are safe

[laugh]. We have how many unknowns?

One. How many questions?

One. Now, life is a little bit complicated if

I, if beta debt is also positive. What I made the problem pretty simple.

What did I say? The debt was largely riskless in this

industry, so I can put zero. Quick question, will this be true usually?

No, unless there's very low level of tech in the whole industry, right?

So typically, just as an example, beta debt is between 0.1 to 0.4.

I'm just giving you broad numbers just to give you a context in which to put it.

Why? Because there's always char, risk in debt

too. Remember this is corporate debt.

This is not, this is not straight forward government debt.

That too, without any coupons. Remember, if you have coupons there's

risk. Okay, can you solve this equation?

Heck, very easy. Beta asset security S will be equal to

1.40 divided by 1.25. You see how that I get, how did I get it?

Because beta asset is beta asset plus 1.25 beta asset and 1.4.

So, beta asset in the software business is 1.4 divided by 1.25 which I believe is

1.12. You see, I've done some homework before I

came. I think this is right and if this is not

just, just do a try, I think it's okay. So, 1.12 is the beta asset of which

business? The software business.

4:14

Let me ask you, what was the beta asset of the video gaming business, was it higher

or lower? One estimate I had was 1.5.

I am calling it one estimate because I took the video gaming business existing of

my own. There could be other companies with video

gaming business, so you want to average these across different because these are

estimates. Okay, so beta asset software business is

1.12. We have almost come.

4:43

Almost come all the way to cost of capital, what have I done here?

Notice one simple thing, if I'd asked you, what is the beta asset directionally of

the software business if I gave you beta equity at 1.4?

You should say what? The maximum beta asset of the software

business can be 1.4 because the beta equity is 1.4.

But because it has debt, the beta asset has to be lowered, [laugh] you know, than

beta equity because equity has financial risk in it.

Okay? You estimate it to be 1.4.

So, let's just start off with a clean slate here and go to the next step.

So, what is the next step now? Cost of capital.

Turns out you know how to do that. Ra of the software business is equal to

what? Rf.

5:44

What equation am I writing? Capm plus Rm minus Rf times beta asset of

software business. You see how cool this is?

I know this is 1.12, but I know this is 4.5, and how much is this?

Five%. Now, this is a little bit all our numbers

can't be well rounded and so on, so there's a little bit off.

So, this is 10.1%. Okay?

Why 10.1? Because 4.5 plus five multiplied by 1.2,

this become 5.6. So, five multiplied by 1.2, this

multiplication is 5.6. So, 5.6 plus 4.5 is 10.1.

We'll treat it almost ten, right? Just, just because we are family.

And I'm going to just worry about the 0.1 when we talk, okay?

So, quick question. Please think this through.

I've done a lot of calculations. But again, the thinking comes before the

pen starts punching numbers. And you didn't need Excel, right?

So let's take a break, come back.